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Why Republicans Favor Revenue From Deductions Over Rate Hikes

Lead negotiators laid out the impasse in fiscal slope negotiations on the Sunday shows. It boils down to taxes, with the White House seeking that increase in the top tax rates, and Republicans claiming to be open on revenue, but only from the capping of deductions or closure of loopholes. Treasury Secretary Timothy Geithner said on CNN “There’s not going to be an agreement without rates going up” on the highest income earners. House Speaker John Boehner countered that there’s no difference between money raised from tax rate increases or deduction caps:

BOEHNER: Listen, what is this difference where the money comes from? We put $800 billion worth of revenue, which is what he is asking for, out of eliminating the top two tax rates.

Since Boehner is the one resisting the tax rate hike, the question should also be put to him. “What is this difference where the money comes from,” indeed? Boehner claimed on Fox News Sunday that increasing tax rates means small businesses will get taxed at a higher rate, “and as a result we’re gonna see slower economic growth.” This makes no sense at all, since he’s repeatedly said that capping or limiting deductions would hit the highest-income earners, and if higher tax rates would hit small businesses, deduction limits would hit them all the same. It’s a tautological argument.

So what’s the real reason here? Why are Republicans for revenue from deductions and dead-set against rates, and Democrats for revenue from top marginal rate increases and not deductions? I can think of a few reasons, but one has gone completely unaddressed in this debate.

First of all, it could be that Republicans are lying, claiming they support “revenue” from loophole closures because it sounds good, but in practice only supporting revenue from economic growth through fuzzy math like “dynamic scoring.” Second, assuming they are legit, closed loopholes are easier to open, particularly without much fanfare, than lowering the rates, something that must get fought out in the light of day. That’s probably the main reason. Rate hikes guarantee more revenue, as Gene Sperling and Jason Furman pointed out, while loophole closures or deduction caps can be fought at some later date. Also, this idea of capping deductions is non-specific enough that you don’t have to directly go up against any one stakeholder who cherishes a particular deduction.

These are all good reasons for Republicans to favor revenue from deductions. But there’s another one. See, when you’re talking about tax expenditures for individual income taxes, you are mostly talking about three very large deductions: the deduction for taxes paid, including state and local taxes; the mortgage interest deduction; and the deduction for charitable giving. Let’s take a closer look at these three deductions.

The mortgage interest deduction is obviously more valuable for higher-value mortgages. By and large, property values are higher on the coasts. The most expensive ten states for housing also all voted for Barack Obama, while 9 of the 10 least expensive voted for Mitt Romney.

As for charitable giving, political science shows that there’s no real partisan divide in donations in the United States. However, there’s this one addendum:

Charitable contributions fluctuate based on the political landscape: Democrats (Republicans) donate less money when a Republican (Democrat) occupies the White House. Conversely, having a co-partisan in the White House increases the average and total donations to nonprofits at the state level.

So what are we left with? A deduction cap, which would hit those individuals with lots of deductions, would have more of a bite in areas with high state and local taxes, high home values, and to individuals with high charitable giving. In all three cases, that leans toward high income earners in blue states (less so in the case of charitable giving but the trend still points toward Democrats). In particular, the Democratic donor class, wealthy blue-state denizens, would get targeted. This isn’t a hard and fast rule; you would have to include people on Wall Street in this equation, and they swung to Republicans in this last election. But their representatives in Congress remain Democrats.

Considering that 93% of all income gains went to the very top, I have no real interest in shielding the rich from the burden of taxation, no matter what state they live in. However, I think this is crucial to understanding the debate. While Democrats favor an increase in marginal tax rates, which would affect all high-income earners equally, Republicans favor revenue from capping or limiting deductions, which strikes unevenly at blue-state wealthy individuals and protects, however marginally, red-state ones. That’s called constituent service. And it explains the position of both sides here.

I would agree that it’s more of a factor that deductions can be closed in future years more easily than lowering rates. But obviously just avoiding the cuts entirely would be the preferable option, which is why Democrats have held to the tax rate position.

So when you hear partisan leaders discuss these issues, keep in mind that Democrats want to raise taxes on the wealthy in a non-partisan way, while Republicans want to basically cause discord in the Democratic donor class ranks by specifically targeting the blue-state rich.